Subsection 74.4(2) - Transfers and loans to corporations

Administrative Policy

a second freeze transaction by a family trust could be viewed as an indirect transfer by the original freezor

As a result of a previous estate freeze, A holds the voting freeze preferred shares of Opco (which is not a small business corporation) and a discretionary family trust (the “Initial Trust”) holds the non-voting common shares. The Initial Trust’s beneficiaries are A, his adult children and his wife and its trustees are A, his brother (B) and an arm’s length individual. Now a further estate freeze is effected under which Initial Trust exchanges its shares for preferred shares under s. 51 and a newly-formed discretionary family trust (“New Trust” – also having grandchildren and family corporations as beneficiaries and with a different unrelated individual as the third trustee) subscribes for new non-voting common shares. Is A’s spouse a designated person in relation to the Initial Trust? CRA responded:

[W]whether it is reasonable to consider that one of the main purposes of a transfer of property is to reduce the income of the individual and to benefit, either directly or indirectly, a designated person (the "Purpose Test”) is a question of fact ... .

In view of the fact that subsection 104(2) provides that a trust is deemed to be an individual in respect of the trust property, subsection 74.4(2) could apply to a trust, assuming that all of the conditions for the application of subsection 74.4 are satisfied.

However, only a person under the age of 18 who does not deal at arm's length with a trust could logically be a designated person in respect of a trust.

In light of the foregoing, the Mr. A’s spouse cannot not be a designated person in respect of Initial Trust.

On the other hand, Mr. A's spouse is still a designated person in respect of Mr. A.

Thus ... subsection 74.4(2) could apply to the transfer of property made by Mr. A, in connection with the estate freeze carried out by Mr. A. in favour of Initial Trust, if the Purpose Test were satisfied.

In addition, we are of the view that the question of the application of subsection 74.4(2) could arise with respect to the estate freeze by Initial Trust if it were determined that the transfer of property effected by this estate freeze was made indirectly by Mr. A through Initial Trust.

Consequently, if it were possible to establish that the Purpose Test was satisfied, subsection 74.4 (2) could also apply to Mr. A in respect of the estate freeze by Initial Trust.

“one of the main purposes” in s. 74.4(2) re freeze trust with minor child acquiring common shares

When asked to comment on factors taken into account in deciding if “one of the main purposes” of a transfer or loan is reasonably considered to benefit a designated person, CRA stated:

In…2001-0067725…we stated that in a situation where a trust of which the beneficiary is a minor child of the freezor acquires common shares of the freezor’s Holdco on an estate freeze, the provisions of subsection 74.4(2) will generally apply, subject to subsection 74.4(4). The taxpayer would have to rebut the presumption that “one of main purposes” of the transfer was not to reduce the income of the individual and benefit a designated person.

1st Situation. Mr. and Ms.X are the sole shareholders of Opco and Holdco, respectively. Opco uses excess liquidity to subscribe for preferred shares of Holdco, which has never been a small business corporation (“SBC”). How would s. 74.4(2) apply? CRA responded (TaxInterpretations translation):

[S]ubsection 74.4(2) does not generally apply when it is a corporation, rather than an individual, who transfers or lends property to a corporation. This legislative provision could however apply if it is demonstrated that an individual indirectly, by means of a trust or otherwise, transferred or lent property to a corporation or if subsection 74.5(6) applies.

…[T]he consideration paid by Opco to Holdco for the acquisition of preferred shares in the capital of Holdco would never accrue personally to Mr. X. Consequently, Mr. X would not be considered, for purposes of subsection 74.4(2), to have transferred, directly or indirectly, property to Holdco. …[W]e refer you to…2002-0147325… .

2nd Situation. Same as 1st situation except that, rather than subscribing for preferred shares of Holdco, Opco declares a dividend on its common shares (held by Mr. X), which is satisfied by issuing preferred shares whose redemption amount is equal to its liquid assets and whose paid-up capital is nominal. The preferred shares are transferred by Mr. X under s. 85(1) to Holdco in consideration for Holdco preferred shares, and Opco redeems its preferred shares in the same amounts as the 1st situation. CRA stated:

[T]he transfer by Mr. X of the preferred shares in the capital of Opco to Holdco would represent…a transfer by an individual of property to a corporation other than an SBC. Furthermore, Ms. X would be…a designated person in respect of Mr. X. Consequently, the provisions of subsection 74.4(2) could apply respecting the transfer, to the extent that the other conditions of its application were satisfied.

3rd situation. Mr. X holds all the shares, having a fair market value of $1M, of Opco, which is not an SBC. Opco declares and pays a dividend on the shares held by Mr. X by issuing preferred shares with a redemption amount of $1M and a nominal paid-up capital. Mr. X’s spouse then subscribes for common shares. CRA stated:

As indicated in [2014-0538041C6 F]…technically subsection 74.4(2) does not apply to the issuance of shares as stock dividends.

Furthermore, the CRA does not generally comment on the application of secton 245 in the context of a request for a technical interpretation… .

annual dividends by an SBC to a non-SBC are not an indirect transfer of property to the non-SBC by the individual who formed the SBC

1st Situation. Mr. X instigates an estate freeze for his corporation (Opco), which is a small business corporation (“SBC”) and all of whose common shares end up being held by the “X Trust” (whose beneficiaries are his grown children, spouse and a newly-incorporated corporation (“Holdco”) which is never an SBC and is held by X Trust). In order that Opco can continue qualifying as an SBC, Opco annually pays dividends to X Trust out of its earnings, which allocates and distributes them to Holdco, making a s. 104(19) designation. Would s. 74.4(2) apply? CRA responded (TaxInterpretations translation):

[T]he provisions of subsection 74.4(2) would not apply to the transfer of property by Mr. X to Opco in the course of an estate freeze so long as Opco remained an SBC.

...[A]lthough the payment of a dividend by Opco to Holdco equal to the surplus funds generated in carrying on the business of Opco could be considered a transfer of property, subsection 74.4(2) generally would not apply where it is a corporation, rather than an individual, which transfers or lends property to a corporation. This legislative provision could however apply if it is demonstrated that an individual indirectly, by means of a trust or otherwise, transferred or lent property to a corporation or if subsection 74.5(6) applied. ...[W]e refer you to ...2002-0147325... . Mr. X would not be considered, for purposes of subsection 74.4(2), to have indirectly transferred property to Holdco.

2nd Situation. Mr. X transfers his business under s. 85(1) to a new corporation (“Opco”) for treasury shares. The other Opco shareholders are his spouse, minor children - and Holdco (which never is an SBC) holding a separate class of shares which are entitled to a discretionary dividend. Mr. and Ms, X, and the children, subscribe for common shares. In order that Opco can continue qualifying as an SBC, Opco annually pays dividends to Holdco out of the surplus funds generated from its operations. CRA stated:

[F]or so long as Opco remains an SBC, [subsection 74.4(2)] would not apply to the transfer of property (the business assets) effected by Mr. X to Opco in the course of incorporating his business, nor ... to the consideration paid by Mrs. X for the acquisition of shares in the capital of Opco. Furthermore, ... Mr. X would not be considered, for purposes of subsection 74.4(2), to have indirectly transferred property to Holdco.

...[T]he consideration paid by Mr. or Mrs. X for the acquisition of shares in the capital of Holdco, which is not an SBC, would technically constitute a transfer of property by an individual (Mr. or Mrs. X) to a corporation other than an SBC (Holdco). Thus, subsection 74.4(2) could technically apply, depending on the other facts and circumstances, to such transfers.

application of s. 74.4(2) to family trust with minor beneficiaries after s. 51(1) freeze in favour of second family trust with same minor beneficiaries

Result of 1st freeze

Trust A (an inter vivos personal trust) holds all the common shares of Opco (a CCPC but not a small business corporation) and Mr. X (who is the sole trustee of Trust A) holds all of its preferred shares as the result of a previous estate freeze transaction. The beneficiaries of Trust A are Mr. X's adult children, their minor children and the adult siblings of Mr. X.

2nd freeze

In a fresh estate freeze transaction, Trust A will exchange its common shares of Opco for preferred shares under s. 51, and common shares will be issued for their fair market value to a new trust (Trust B), whose beneficiaries are the same as for Trust A, plus Mr. X, his ex-spouse and any corporation controlled by one or other of the beneficiaries (other than any corporation in which Trust B has a direct or indirect interest).

Q&A

Who are the individual and the designated persons for purposes of ss. 74.4(2) and 74.5(5)? After referring to the ss. 104(1) and (2) definitions, CRA stated (TaxInterpretations translation):

[T]he individual, for purposes of subsection 74.4(2), would be Trust A.

Respecting who are the objects of the test provided in subsection 74.4(2), which refers to where it may reasonably be considered that where one of the main reasons for a transfer or a loan of property to a corporation may be to reduce the income of the transferor and to benefit a designated person in respect of the individual, we are of the view that a designated person in respect of Trust A would include, in this situation, a person under 18 years who would be beneficially interested in Trust A if subsection 248(25) applied without taking into account clauses (b)(iii)(A)(II) to (IV), or a person under 18 years who did not deal at arm's length with a person who would be beneficially interested in Trust A if subsection 248(25) applied without taking into account clauses (b)(iii)(A)(II) to (IV). This follows from the definition of designated person in subsection 74.5(5), and from paragraph 251(1)(b) which indicates that a taxpayer and a personal trust are deemed not to deal at arm's length.

Mr. X holds all 100 of Opco's Class A shares with a fair market value of $1,000,000 and nominal ACB and PUC. Opco pays a stock dividend comprising Class B shares which have a retraction right for $900,000; the 100 Class shares are exchanged for estate freeze Class C preferred shares; and the family trust subscribes for Class A shares for $10. (Consistently with 2003-0004125 F) would s. 74.4(2) not apply to the Class B shares issued on the stock dividend? What would be the safe income attributable to the Class B shares issued as the stock dividend? If the shares of the corporation instead were held equally by three shareholders and the steps otherwise were the same except that the new common shares would be issued to three family trusts, would s. 15(1.1) would apply to the stock dividend. CRA responded (Tax Interpretations translation):

In general, a stock dividend paid by a corporation does not constitute in itself a transfer directly or indirectly (by means of a trust or otherwise) to a corporation by an individual. Thus, the provisions of ITA subsection 74.4(2) would not apply so as to calculate deemed income on the value of the Class B shares received in satisfaction of the stock dividend.

In contrast, the exchange of the 100 Class A shares of Opco for preferred Class C freeze shares would constitute a transfer made directly or indirectly (by means of a trust or otherwise) to a corporation by an individual for purposes of ITA subsection 74.4(2).

the agreement reflects a bona fide intention of the parties to transfer property at FMV;

the purported FMV is determined by method that is fair and reasonable in the circumstances (which does not necessarily entail using CRA's preferred method, nor engaging a valuation expert);

the parties agree that a CRA or Court valuation, if any, will supersede the price otherwise determined; and

the excess or shortfall is actually refunded or paid, or legal liability therefor is adjusted (para. 1.5).

Price adjustment clauses involving shares may use a number of adjustment mechanisms. CRA non-exhaustively mentions changes in redemption value, the issuance of a note or change in the principle amount of a note, or a change in the number of shares issued - although CRA recommends against using the latter because of inherent legal and technical difficulties (para. 1.6).

In Situation 1, Mr. A holds all the shares of Opco, being 100 common shares having a FMV of $800,000. Opco declares and pays to Mr. A a stock dividend comprising 800 preferred shares with a redemption amount and FMV of $1000 per share, so that the FMV of the common shares is reduced to $100. Immediately thereafter, a trust for his children subscribes for 1000 common shares of Opco for $1000. Does s. 74.4(2) apply? CRA responded (TaxInterpretations translation):

[I]n general, a stock dividend paid by a corporation does not constitute in itself a transfer directly or indirectly (by means of a trust or otherwise) to a corporation by an individual.

5 March 2001 External T.I. 2001-006772 -

Subject to s. 74.4(4), the provisions of s. 74.4(2) will apply to a typical estate freeze whether it utilizes s. 85(1) or s. 86.

20 March 1997 T.I. 963505

"In a situation where subsections 74.1(1) and 74.2(1) of the Act apply to attribute to an individual the income or loss from transferred property and the taxable capital gain or allowable capital loss arising from the property, it would appear to us that one cannot generally say that one of the main purposes of the transfer of the property by the individual to his or her spouse is to reduce the income of the individual and to benefit the spouse. Therefore, provided that subsections 74.1(1) and 74.2(1) of the Act apply, and subsection 74.5(11) of the Act does not apply, then subsection 74.4(2) of the Act would not normally apply to deem the individual to have received an amount as interest."

20 March 1995 T.I. 942992 ("C.T.O. 74.2(2) and Amalgamation")

Where a holding company amalgamates with its operating subsidiary, there will be considered to be a "transfer of property" to the amalgamated corporation for purposes of s. 74.4 if, as a result of the amalgamation, shares of the holding company are cancelled by it and new shares are issued.

12 October 1994 External T.I. 5-941148 -

"Technically the application of subsection 74.4(2) of the Act could change from time to time if a corporation moved from being a small business corporation to a non-small business corporation and back to a small business corporation."

Where a corporation ("A") owned by an individual amalgamates with a second corporation ("B") owned by a trust for the benefit of the individual's infant children, s. 84(9) of the Act would result in a disposition of shares of A to Amalco if, as a result of the amalgamation, shares of A were cancelled by A and new shares were issued. In such event, there would be considered to be a "transfer of property" to Amalco for purposes of s. 74.4. The individual would not be regarded as having transferred property of A indirectly to Amalco.

S.74.4(2) would not apply where a corporation (as opposed to an individual) transfers or loans property to another corporation unless an individual may be said to have indirectly transferred or loaned property to the other corporation, or s. 74.5(6) is applicable.

26 January 1994 External T.I. 5-932995 -

Where one's spouse guarantees a bank loan made to an investment company owned equally by both spouses, s. 74.5(7) will not permit the interest payments made to the bank by the investment company to be deducted when making the calculation under s. 74.4(2)(e), because the guarantor will not be deemed to have received such interest payments. However, the purpose test in s. 74.4(2) will not be satisfied only by the fact that an individual guarantees an arm's length loan made by a bank at a commercial rate to a corporation of which his spouse owns not less than 10% of the issued shares of one class.

30 March 1993 T.I. (Tax Window, No. 29, p. 23, ¶2454)

There is no provision for a reduction in the amount of attributed income where the income actually earned by the corporation is less than the prescribed rate.

92 C.R. - Q.34

The transferee corporation in s. 74.4(2)(c) is required not only to be a small business corporation at the time of the transfer, but also throughout the period for which the exemption from imputed interest is sought.

21 August 1992 T.I. (Tax Window, No. 23, p. 24, ¶2154)

Any rights or dividend entitlements attached to preferred shares held by an individual would not by themselves be indicators that a particular transaction does not benefit a designated person.

27 June 1991 Memorandum (Tax Window, No. 4, p. 13, ¶1320)

Discussion of the application of the main purpose test where an individual transfers shares of an operating company to a holding company and those shares are subsequently redeemed by the operating company.

11 June 1991 T.I. (Tax Window, No. 4, p. 29, ¶1298)

The fact that the property transferred to the corporation does not produce income (e.g., it is vacant land) may be an indication that the reduction of the transferor's income was not one of the main reasons for the transfer.

2 November 1990 T.I. (Tax Window, Prelim. No. 2, p. 14, ¶1080)

The purpose test in s. 74.4(2) must be applied separately to each transfer of property, with the result that imputed income on a transfer which does not meet the purpose test effectively cannot be off-set by excess income received as the result of a transfer of property that does not violate the purpose test.

30 January 1990 Memorandum (June 1990 Access Letter, ¶1263)

The receipt by an individual (who some years earlier had effected an estate freeze) of a stock dividend on his preferred shares did not entail a direct or indirect transfer of property to a corporation.

ATR-36 (4 Nov. 88)

A favourable ruling is given with respect to an estate freeze involving a trust which will provide that "no amounts will be paid or payable to or for the benefit of, a particular beneficiary of the Trust until that beneficiary has attained the age of 18 years."

Subsection 74.4(4) - Benefit not granted to a designated person

Administrative Policy

having a trust interest vest indefeasibly in a minor is consistent with the minor not receiving or having any use of the trust capital

A discretionary inter vivos family trust (the “Old Trust”), which was approaching its 21st anniversary, had provisions in its declaration of trust which contemplated that, prior to that anniversary, the trustee would make an irrevocable declaration establishing the respective shares to the trust fund of the family beneficiaries, so that the trust fund would be distributed to those beneficiaries except those who were “designated persons” (i.e., grandchildren who were minors), whose respective shares as so determined would instead be held for them until they attained the age of majority. Designated person status was relevant under s. 74.4 given that the Old Trust had subscribed for common shares of a holding company (ACO 1), which had been formed to hold shares held by the family patriarch (Mr. A) of a Canadian public company (Pubco), in connection with an estate freeze transaction. After an amalgamation of ACO 1 to form ACO 2, the Old Trust transferred its common shares of ACO 2 to Holdco for Holdco common shares.

In order to address “ambiguities” in the declaration of trust for Old Trust, a judgment was obtained from the Quebec Superior Court declaring that the ambiguities were resolved as sought by the trustee. All the assets of the Old Trust (being mostly the common shares of Holdco) were transferred to a new trust (“New Trust”), whose trustee was the same “Initial Trustee,” and whose terms were “for all practical purposes” the same as for the Old Trust but “adjusted to take into account the conclusions of the declaratory judgment rendered.”

CRA ruled that this transfer was deemed not to be a disposition under the exception in para. (f) of the s. 248(1) disposition definition (and so that s. 248(25.1) deemed the new trust to be a continuation of the old), and also provided an opinion that the making by the trustee of the designation, which was deemed under the New Trust terms to become irrevocable immediately before the 21st anniversary of the Old Trust (or on him ceasing to be a trustee, if sooner), thereby causing all the interests in the new trust to indefeasibly vest in the beneficiaries in accordance with their declared shares, did not detract from the minor grandchildren continuing to comply with s. 74.4(4)(b). In particular, CRA opined that provided that the terms of the Deed of Trust for the new trust are such that a designated person beneficiary may not receive or otherwise obtain the use of the income or capital of the trust before the date of death of Mr. A, the irrevocable determination respecting all interests in the capital and income of the new trust will not, by itself, result in the requirements of s. 74.4(4)(b) not being satisfied respecting the transfer of the shares of Pubco to ACO 1 described above.

X holds all the common shares of Opco. An inter vivos trust for the minor children of X ("Trust") holds all the common shares of Holdco. X transfers all his common shares of Opco to Opco in consideration for preferred shares of Opco and, at the same time, Holdco subscribes for common shares of Opco. Does s. 74.4(a) require that the trust hold the shares of the transferee corporation directly?

Scenario 2

X holds all the common shares of Opco 1 and 2, and Opco 1 holds the preferred shares of Opco 2. X transfers all his common shares of Opco 1 to Opco 1, and of Opco 2 to Opco 2, in consideration for preferred share of Opco 1 or Opco 2, as the case may be and, at the same time, an inter vivos trust for the minor children of X ("Trust") subscribes for common shares of Opco 1 and Opco 2. Is s. 74.4(a) satisfied respecting the transfer made by X to Opco 2 as the trust holds shares of Opco 2 both directly and indirectly through Opco 1? CRA responded (TaxInterpretations translation):

… Scenario 1…[T]he condition provided in paragraph 74.4(4)(a) would not be satisfied by reason of the shares in the issued share capital of Opco not being held by Trust but rather by Holdco. …[T]his situation could be corrected if Trust, rather than Holdco, subscribed for the new common shares in the capital of Opco.

… Scenario 2…[T]he designated person would have two interests in Opco 2… .

Thus, respecting the interest which the designated person would have in Opco 2 by means of Opco 1, the condition stipulated by paragraph 74.4(4)(a) would not be satisfied because the preferred shares in the capital of Opco 2 would be held by Opco 1, and not directly by Trust.

8 February 1993 T.I. (Tax Window, No. 29, p. 7, ¶2422)

Where the grandfather of the taxpayer settles a trust of which the taxpayer is a beneficiary, and the taxpayer's father contributes shares of a corporation to the trust, the conditions in 74.4(4) will be met if the taxpayer has no other interest in the corporation, he is only entitled to the income and capital of the trust after his father's death and he does not receive or otherwise obtain the use of any of the income and capital of the trust while he remains a designated person in respect of his father. If his father dies before he attains 18 years, s. 74.1(2) may apply to deem his revenue from the trust to be his grandfather's revenue.

Articles

Example of refreeze following a decline in FMV of freeze shares (p. 7)

Mr. X…transfers his common shares of Opco, worth $15 million to Holdco pursuant to section 85 ("the first transfer"). As consideration, he receives from Holdco $15 million of class A preferred shares. A family trust with beneficiaries who are designated persons vis-à-vis Mr. X subscribes for the common shares of Holdco. Holdco is not … a small business corporation. One of the main purposes of the transaction is to reduce the income of Mr. X and benefit the designated persons ("the purpose test"). The trust does not qualify as a subsection 74.4(4) trust, so Mr. X cannot avoid attribution under that section. Due solely to the economic downturn, the FMV of Opco declines to $3 million. Mr. X then exchanges his $15 million of class A preferred shares of Holdco for $3 million of class B preferred shares of Holdco pursuant to section 86 ("the second transfer ")….

[T]he purpose test is not met for the second transfer;…

Inability to reduce the outstanding amount for the FMV decline (p.7)

[T]he outstanding amount is reduced—but only from $15 million to $12 million—upon the redemption of the class B preferred shares, because the cash consideration received by Mr. X does not represent excluded consideration.

This phantom outstanding amount of $12 million will be subject to corporate attribution...forever…

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